One should keep in mind that it is not really the total amount of debt that matters but rather the carrying cost of that debt. For example, if interest rates are zero, then it doesn't really matter how much debt you have since your interest payments are practically negligible. Interest rates have been dropping steadily since the Volcker recession in the early 1980s and are now essentially at zero.

Now have have clearly reached one of those great turning points in economic history. What is to happen next?

Well, if the US were not the powerful economic and military superpower and holder of the reserve currency the outcome would be fairly obvious. We would suffer the same fate as Iceland or Argentina. Other countries would stop lending to us and refrain from investing in our country. Our currency would plummet and interest rates on our debt would sky rocket. Since a lot of our debt would be in other currencies, devaluing our currency would only alleviate our problem to a limited extent. We would go begging to the IMF for a bailout and would receive it only by accepting their terms which would include higher taxes and in effect a lower standard of living.

However, the US is not Iceland. The US debts are almost entirely in US dollars. The US dollar is also the reserve currency of most central banks. The US is not only the sole military superpower, it is the largest source of consumer demand in the world economy. If any central bank or ALL central banks decide to sell off their dollar denominated holdings and give up the US dollar as reserve currency, the dollar will drop and there will be major economic as well as political consequences.

Loss of competitiveness in exports as US exporters benefit

Loss in the value of US dollar reserves

Major restructuring costs as the world economy rebalances

US power decreases as it can no longer run large deficits

Power shifts eastward, the consequences of which are uncertain

The politicians of Asian countries (China in particular) might not be able to withstand a large loss of jobs in exports. For this reason they might not be too keen in allowing the dollar to weaken. This is not a question of whether it is better for them in the long run. It is a question of whether they can throw a lot of people out of work and still remain in office. The European's might not like the monetary situation which empowers the US but probably prefer it to one in which Asia hold more power. They after all share a common culture and are military allies. Likewise Japan and Saudi Arabia (among others) depend on the US military and so have reason to sustain the current situation. So it seems that it is unlikely that any drastic change in the US dollar as reserve currency will be precipitated from abroad. It doesn't appear to be in the best interests of these countries. Asia is too dependent on exports to the US and if Asia does not dump the dollar it is unlikely that anyone else will since that would just allow for a further loss in competitiveness to Asia.

But, one way or the other, the US needs to restructure its debt. Fortunately, there is a way. The Federal Reserve can simply print money and monetize the debt. It could if it wished, simply buy every outstanding loan and then restructure the loan any way it wished. It could simply forgive all the debt and in doing so reduce the debt to zero. This is of course the extreme case but there is nothing in principle stopping the Fed from devaluing the dollar and reducing the real value of this debt load. Some people have a knee jerk response that this is preposterous and would never work. They say, it would cause our foreign debt holders to immediately sell their Treasuries which would cause yields to spike. But this is incorrect. The Fed has unlimited amounts of dollars and could choose to buy every US treasury at 0% yield if they wished. This would effectively make Treasuries and dollars exactly equivalent. If our foreign debt holders wish to sell them, they would simply end up with dollars. They would have to spend those dollars in the US boosting US exports or buy US assets like stocks and real estate.

Now of course this is highly inflationary. The US money supply is roughly $10T. If the Fed converted $50T in debt to $50T in dollars, this would increase the money supply roughly by a factor of six. Every real asset would be about 6 times more expensive. That would be the cost of eliminating all of our debt. However, even in this extreme scenario, this is not really hyperinflation. A devaluation by a factor of six is roughly the same as was experienced in the US between 1960 and the present. It is not like Zimbabwe whose currency has an inflation rate (Dec 2008) of 516 quintillion percent (516 followed by 18 zeros).

Now, the Fed need not erase all of the debt. It would be enough to reduce household debt by $5T which would put the US household back to where it was in the late 90s. It could also do things like buy up all the credit card debt from the US banking system (there is about $2.6T) and refinance it at a fixed 5% interest rate. Keep in mind that the average interest rate on credit cards is about 17%. This would greatly reduce the interest payments for US consumers and keep the debt from growing too quickly. They may even be able to pay it off. It could also offer to buy any outstanding mortgages at face value (or some reasonable discount to that) and refinance them at a lower principal to reflect the lower home price. This would keep many of these people in their homes and repair the balance sheet of the American homeowner. It would also be a giant bailout for the US banking system. Businesses then would also want some kind of bailout. Where this stops is hard to know. The point is, that the Fed has almost unlimited power in terms of printing dollars and spending them wherever they want. If they lack certain powers, the congress can vote to give them new ones. But the US itself has the power to determine the real value of their debt since it is entirely in their own currency.

Foreigners can gripe out how we have duped them. They have traded real assets for pieces of paper and then we devalued those pieces of paper. But they can't simply blame us. They knew what they were getting into. They never expected us to act in any other way then what was in our own best interest. The situation is akin to a bank who makes loans to people unable to pay them back. They deserve to share the pain. There is really no other way. They may be harmed even more if the US does not prevent deflation from setting in. Deflation in the US will simply spread to every other country.

What will result from this however is that we will have to give up forever the idea that we operate under a capitalistic system. We will have to admit the role of the Federal Reserve as massive central planner. What looks like capitalism is really play-capitalism and when the play gets too rough, mommy comes in and breaks it up.

The result of all of this is likely to be a more balanced world economy. The world will be a lot more reluctant to lend money to the US. But the US will have less need to borrow since its debt load will be reduced. Perhaps the dollar will remain devalued and the US can export more and erase the trade deficit. Of course lots of things can go wrong. But one should keep in mind the tremendous power of the Federal Reserve in being able to create as many dollars as it wishes. The outcome will not be determined simply by economic factors. Political factors are at least as important for an economy with a fiat monetary system.

Would printing by the Fed be fair? Well, if your attitude is that anyone who borrows is morally obliged to pay it back then the answer is no. But the world isn't fair. Countries all act in their own best interest. That should not surprise anyone who is a realist. Paying back our debt in full value is not in the best interest of the United States and might not even be in the best interests of our debtors. Likewise, since bankruptcy is always an option, it benefits banks to restructure the loans to consumers so that they can service them. Obviously, some ways of restructuring the debt are more fair than others. It is uncertain how far the Fed would go or how far they would need to go.

So what are the investment implications? Well, the Fed probably won't be able to act too aggressively until the situation has worsened further. They need political cover in order to convince the US and foreign politicians that there is no other way. So stocks will likely fall further as earnings vanish. The weaker businesses will fail and other banks will be brought down. Panic is likely to rise as the world economy approaches the brink of complete meltdown. The near term outlook then is for deflation. At some point however there will be no more deflation plays. Yields on treasuries will have approached zero. Stocks will have fallen to extremely low valuations. Bonds will be in a bubble. At this point, the Fed will act aggressively to reflate the economy. So stocks will be a good bet here and also commodities. Gold should do well as there will be great uncertainty of the future monetary system and the dollar is likely to end up devalued. Stocks that may do the best are those with low debt and plenty of foreign currency exposure. In particular, ones with less exposure to bad, or at least uncertain, economic conditions. JNJ, CL, KO come to mind. Times of economic and political turmoil will likely be good for the consulting agency ACN. Energy companies should do fairly well though probably less well than the past few years. I will revisit this in more detail in the future.